What Style of Index Investing Is Right for You?

Find out what you need to know about index weightings before you invest.

By SHARE

For years, traditional market cap-weighted index funds have been the go-to product for passive investors. Besides being inexpensive, tax-efficient, and transparent, studies show they tend to outperform their actively managed counterparts over the long term.

But over the past several years, alternative forms of indexing, such as fundamental and equal weighting, have gained momentum. These indices preserve some of the low-cost and tax benefits of conventional index funds, but by taking different security weighting approaches, they aim to correct perceived inefficiencies in traditional, market-cap indices to produce better returns.

[See 9 Strategies for This (Or Any) Market.]

In the roughly five years since they were introduced, alternative indices have often performed better than their cap-weighted counterparts, but experts caution that investors shouldn't be lured to a particular index style based on performance alone. With each indexing method comes unique benefits and risks. "There's no one style or construction ... that's necessarily better than the others at all times," says Tom Graves, exchange-traded fund and equity analyst at Standard and Poor's. "There are a number of different ways you can weight an index, and there are potential advantages and disadvantages to all the major categories."

U.S. News asked the experts to break down the different indexing styles to help you find the right fit for your portfolio:

Market-cap indexing. The most predominant form of indexing assigns weights according to a company's market capitalization, or the market value of their outstanding shares. That means companies with the largest market capitalizations have more of a presence in an index than companies with smaller market capitalizations.

For example, consider the weightings of the S&P 500, which includes the largest 500 U.S. companies. As the share price of computer and software giant Apple has skyrocketed over the past several years, its weight in the S&P 500 has swelled accordingly—currently, it's second only to Exxon Mobil.

The primary benefits of market cap-weighted indices are twofold, says Morningstar analyst Paul Justice. "The chief benefit of the market-cap index was that one, it was really reflective of the overall stock market, [and] two, that it minimized the turnover costs," he says. "Basically, a stock would reweight itself just as its price appreciated. You don't have to rebalance that index."

[See Why ETF Investors Need to Do Their Homework.]

Because securities shuffle less frequently in market cap-weighted indices, less buying and selling occurs, which keeps trading costs and capital gains taxes (assessed if a security is sold at a gain) to a minimum.

While market-cap weighting is the most entrenched indexing method, critics say it can lead to wild swings and periods of boom and bust, such as what investors experienced during the 90's tech bubble or more recently, the financial sector meltdown in 2008. (Investors in funds tracking the cap-weighted S&P 500 index saw the value of their funds plummet 37 percent that year.) "They fundamentally do the wrong thing, which is let winners run until the last minute, like how they got so tech-heavy just before the dot-com crash," said David Nadig, director of research for Index Publications (which publishes the Journal of Indexes), in a recent Smart Money article.

Nevertheless, experts say market-cap weighted funds still have a place in a well-diversified portfolio. "In a momentum market, cap-weighting is going to win," says James Early, advisor of the Motley Fool Income Investor newsletter and a former hedge fund analyst. "If we are in a kind of raging bull market, you want to be in a cap-weighted [fund] because the faster-growing stuff is just going to naturally assume a larger portion of your portfolio." Ultimately, it comes down to diversification, he says, and having a spread of index funds that can perform well in all types of market climates.

Alternative indexing. These indices come in two main varieties: equally weighted and fundamentally weighted. As its name suggests, the equal-weighted approach portions out index weights equally so that individual large-cap stocks have just as much weight as individual mid- or small-cap stocks. For example, each holding in Rydex's S&P Equal Weight ETF (symbol RSP), which tracks the S&P 500 index, has a 0.2 percent weight (or 1/500th) in the portfolio. Fundamentally weighted indices weight securities based on specific business metrics or a combination of business metrics, such as revenue, dividends, earnings, sales, or cash flow. For example, fundamental ETF firm RevenueShares weights on revenue, while another, WisdomTree, weights on dividends and earnings. (For a more detailed explanation of how fundamental indices work, see Fundamental ETFs Go Beyond Index Investing.)